1.
Employer sponsored pension plans
2.
Registered Retirement Savings plans (RRSP)
3.
Non-registered savings
4.
Canada Pension Plan (CPP)
5.
Old Age Security (OAS)
6.
Government Income supplements for
individuals/couples with low incomes
Let’s
take the ‘employer sponsored pension plans’ first. Generally
these plans come in two flavours.
Defined
Benefit Plans: Your
pension at retirement is based on a pre-determined formula (defined
benefit), which is basically like this:
Annual
Retirement Pension=Years of service x Employment income at
retirement x Pension factor, X
X
is a percentage, generally, in the range 1 to 2%. So if you work
for a company for 20 years and your employment income at the
time of retirement is, say, $60,000/yr, then assuming X to be
2%, your annual pension (at age 65) would be:
Annual
pension at 65 =20 x 60000 x 2/100
=$24,000/yr
Both
the employer and the employees fund these plans. The
employee’s contribution is fixed at a certain percentage of
the employment income. However, the employer carries the burden
of funding the plan adequately, so that the future liability
related to the employee’s pension is met. In this sense, these
plans are excellent from the employees’ point of view (you
know what you are contributing and you also know what you are
getting). However, these plans place an additional financial
burden on the employers and for this reason, many employers
choose to move away from such plans. Also, in the recent times
it is becoming increasingly difficult to visualize a scenario
where an employee will stay for twenty or more years with one
single employer. In order to enjoy the full benefits of such
plans, a long length of service is very important.
Defined
Contribution Plans:
In
these plans both employer and employees contribute at a
predetermined rate (usually a percentage of employment income).
The employee is offered a range of investments within which both
the employer and employee contributions may be invested. Usually
the employee has the responsibility of making the investment
decision. Naturally the pension income that may be derived from
these investments will depend on the size of contributions,
investment rate achieved and time period. In other words, in
these plans you know what you are putting in (defined
contribution) but you don’t know for sure what you are
going to get. Naturally such plans suit the employers since now
they don’t have to promise you a future pension. For the
employees, these plans bring the element of uncertainty in their
retirement plans. Well, that’s life!
Registered
Retirement Savings Plans (RRSP): As the name suggests
this is essentially a retirement savings plan (RSP) that has
been registered. Generally speaking, you can choose whatever
investment meets your investment & savings criteria as your
RSP i.e. every year you could set aside $X in an investment of
your choice and think of it as your retirement fund. Naturally
you would be funding such an account with your after-tax dollars
and furthermore, every year you would be taxed on any income
(dividend, interest etc.) generated by these investments.
Conversely, when you choose to withdraw these funds your tax
liability would be limited to the capital gains on the
investments. It is in this tax treatment that a RRSP differs
from a conventional RSP.
In
an RRSP the amount that you contribute
to your RRSP is tax deductible i.e. if you contribute $1,000 to
your RRSP, you can reduce your taxable income by $1,000, which
would reduce your tax liability.
The
income generated by investments within the
plan, are sheltered from taxes i.e. say in year 2001 your plan
generated an interest income of $1000. While doing your tax
return for year 2001, you will not include this amount in your
taxable income. This is ‘tax free compounding’. a very
powerful feature of RRSPs.
The
maximum amount that you can contribute to your RRSP in a
particular year is (18% of your
previous year’s earned income or $13,500 whichever is lower)
minus (Pension Adjustment. a figure that reflects the value of
the benefit derived during the year from an employer sponsored
pension plan) plus any Unused RRSP contribution room carried
forward from previous years.
You
can withdraw these funds any time. However, in the year of
withdrawal the entire withdrawn amount is treated as income and
taxed accordingly. Therefore, barring any unavoidable financial
emergency, you would not draw funds from this plan except during
the retirement stage.
At
age 69, the entire RRSP has to be rolled over into a Registered
Retirement Income Fund (RRIF) from which you have to take out at
least a certain minimum amount (specified by Canada Customs
& Revenue Agency – CCRA) every year. Though you cannot
contribute any RRSPs to the RRIF plan, the plan still continues
to enjoy its tax-sheltered status. Since
RRSP contributions and withdrawals have tax implications, these
plans have to be registered with the government and supervised
by a Trustee. The trustee essentially ensures that the specific
investments meet the government criteria of eligibility and
issues tax receipts for contributions & withdrawals.
Most
financial institutions in Canada offer RRSPs and there is
multitude of eligible investments ranging from Savings a/cs,
Canada Saving Bonds, GICs to mutual funds, stocks, bonds etc.
While
RRSPs are generally touted as a great tax-planning vehicle
(which is true), its main strength lies in ‘tax free
compounding generally over a considerable length of time’. For
a 40 year old with life expectancy of, say, 80 years you are
looking at 40 years of tax-free compounding. That’s powerful!
Wuzz
up dude ?
So
what’s up ? Well, let’s see. DJ Industrial is down 5% this
year. DAX is down 9%, Nikkei is down 10% and oh yes, good old
London is down about 12%. Our home Toronto (TSE300) is down
about 15% and finally, to crown it all, dear ole Bharat (BSE200)
is down about 25%! Pardon me for not mentioning a few exceptions
like Mexico, Australia etc. that have actually posted positive
numbers this year. In short, globally the markets and
consequently, the investors have been ‘depressed’ for over a
year now. Considering that prior to that we were having a great
Bull market for a very long time, the arrival of the Bears has
ruined the party for a large number of investors.
So when did it all begin? Last summer with the onset of
Technology sector meltdown? Did it have anything to do with the
preceding breathtaking rise in the darling of technology stocks
the NASDAQ composite? You remember someone referring to
‘irrational exuberance’? Then there was that changing of
guards between the ‘old economy’ and the ‘new economy’.
The global village tied together with the internet, linked with
super fast communications, and of course the biotechnology
revolution…..all that was going to change our lives the way we
know it.
What does all this do to our financial plans and investment
strategies? Have the market forces undergone a fundamental
change and if so, should we discard our old financial tools and
invent new ones? To understand this let us do a quick recap of
what financial planning is all about. Your Net Worth (assets
less liabilities) represents where you are today, financially
speaking. This is what you have managed to accumulate so far.
Let’s call this point ‘A’. You have some financial
goals….retirement, children’s university education
($10-15k/yr in Canada), reduce taxes (we are one of the highest
taxed countries and we are working hard to be number one!) etc.
Each goal would have a time frame (retire in 30 years) and a
dollar cost ($5000 per month income at retirement) associated
with it. Let’s call one of these goals as point ‘B’. A
financial plan would examine these goals in light of your
current financial situation (Net Worth & Cash Flow) and
suggest workable strategies for achieving those goals. This
effectively is the path that takes you from point ‘A’ to
point ‘B’. Some of these paths may involve investing money
such that the future value of these portfolios is sufficient to
meet the cost of the particular goals. For each of these
investments the ‘time frame’ is a critical factor.
Why is ‘time’ a critical factor for investments? Well, time
represents your ‘investment horizon’. Every investment has a
time horizon associated with it. For example, money deposits
with banks etc. guarantee you your principal and may be suitable
for investments with a short time horizon. At the other end of
the investment spectrum we have investments related to stocks
(oh those wonderful tech & biotech stocks) which do not
guarantee the principal but do promise (not legally enforceable,
unfortunately) considerably higher returns on your investment.
These investments are ‘volatile’ meaning that over short
periods of time their prices may fluctuate dramatically. Which
means that such investments may not be suitable for an investor
with a short investment horizon. For example, if you had bought
Nortel, Canada’s pride & jewel, last year at $120 hoping
to make a ‘quick buck’, you would be lucky to get $15 today.
In other words you are out of luck. On the flip side you would
have learnt the value of picking investments consistent with
your investment goal.
So what is an investor to do in this stock market? Back to
basics. Fundamentals. Simple as that. Do you have a workable
financial plan? Why are you investing? What is your investment
(time) horizon? Do you have the time and the financial
wherewithal to weather the storm? For short-term goals (buying a
car in 6 months) use simple guaranteed investments. For long
term (e.g. retirement for people south of 60) consider stocks
related investments. If you like a new sector in it’s infancy
(biotech?) and you have a long term horizon (and the appetite)
then consider mutual funds instead of individual stocks. And
always ask yourself ‘Am I an investor or a Speculator?’ If
you are an investor odds are you’ll get through the mess we
are in today. If you are a speculator, you may want to search
the net for keyword ‘Prozac’.
___
*Ashok
Raturi is an Electrical engineer from IIT Delhi. He completed
his MBA from IIM Bangalore with specialization in Finance. After
pursuing Project Management for some time, he moved into the
field of Financial Planning 8 years ago. He now has his own
financial planning practice for individuals & families
where, in his words, he ‘happily dispenses advice, financial
& otherwise’. He may be contacted at ashok@rifp.net.
